Bitcoin as a deflationary force for bank fees

Today’s commentary

I am doing this outside the paywall because I think it is important that everyone get this idea.

In the wake of the financial crisis, bailouts and cheap money have done much to restore American bank balance sheets. Earnings for banks have returned to pre-crisis levels. But over the medium-term I believe banks’ earnings power will be damaged by a loss of fee income as bank fees come under assault. The problem is Bitcoin. Let me explain in this post.

As the new year began, I began producing a TV show on the economy called Boom Bust that airs at 430 ET every night on RT America, the American arm of the Russian broadcaster RT. The anchor, Erin Ade, uses the show as a platform to talk about everything under the sun in the world of finance, markets and economics with each show centered around lengthy interviews with one or two guests. Of course, you should be watching this show! Here’s the YouTube page for you to subscribe. That’s my obligatory plug for the show.

At the end of each show, Erin and I have been talking for four or five minutes about a specific economic topic that we think is interesting . Last night, after the show with Steve Keen on private debt and the Australian economy, we talked about Bitcoin.

(video below – Bitcoin segment is at the end)

Right now, Bitcoin’s price is going through a parabolic move reminiscent of the Nasdaq bubble of the late 1990s. That’s Bitcoin the currency. But just as Amazon and Yahoo’s parabolic moves in the late 1990s don’t diminish the promise of the Internet, Bitcoin’s bubble-like valuation as a currency doesn’t diminish the promise of the payment system.

Every new technology on the pike goes through a gold-rush frenzy period in which we see massive speculation and innovation before the true promise of that technology comes to the fore. This was true with railroads in the 19th century – something that brought us the Panic of 1847 in the UK and the Panic of 1873 and the subsequent Long Depression. It was also true about the auto industry where we saw a massive shakeout of auto companies as Charles Stewart Mott formed General Motors through a consolidation of scores of other car companies. And it was true most recently in the Internet, a space that went through a true depression of financing after the Internet bubble burst before the latest wave of innovation.

As I wrote on Twitter recently, Bitcoin is a natural progression of the Internet, which is designed around failures in distributed anonymous systems. I see Bitcoin as a payments system that  for the first time does not rely on a sponsor like PayPal or on a link of central nodes like the SWIFT transactions communication system or any traditional banking payments system. Instead, the Bitcoin payments system uses the distributed nature of the Internet to form a distributed system with high levels of algothrithmic fault tolerance.That is a very big deal. It means that for the first time ever you can have a payments system that is at once a robust distributed network but without trust in the sponsor of central network nodes as a prime facet.

The other day, Marc Andreessen, who is a VC in Silicon Valley and a founder of Netscape, wrote what I think is a must-read piece on why Bitcoin matters. Here’s the part that I want to concentrate on:

Bitcoin at its most fundamental level is a breakthrough in computer science – one that builds on 20 years of research into cryptographic currency, and 40 years of research in cryptography, by thousands of researchers around the world.

Bitcoin is the first practical solution to a longstanding problem in computer science called the Byzantine Generals Problem. To quote from the original paper defining the B.G.P.: “[Imagine] a group of generals of the Byzantine army camped with their troops around an enemy city. Communicating only by messenger, the generals must agree upon a common battle plan. However, one or more of them may be traitors who will try to confuse the others. The problem is to find an algorithm to ensure that the loyal generals will reach agreement.”

More generally, the B.G.P. poses the question of how to establish trust between otherwise unrelated parties over an untrusted network like the Internet.

The practical consequence of solving this problem is that Bitcoin gives us, for the first time, a way for one Internet user to transfer a unique piece of digital property to another Internet user, such that the transfer is guaranteed to be safe and secure, everyone knows that the transfer has taken place, and nobody can challenge the legitimacy of the transfer. The consequences of this breakthrough are hard to overstate.

People need to stop fixating on Bitcoin the currency and start focusing on Bitcoin the technology. The technology is the big deal because Bitcoin is a low-cost and global instantaneous payments system that uses the distributed nature of the internet to create a robust platform with hundreds of potential uses. Andreessen gave a few examples in his article:

Think about digital signatures, digital contracts, digital keys (to physical locks, or to online lockers), digital ownership of physical assets such as cars and houses, digital stocks and bonds … and digital money.

All these are exchanged through a distributed network of trust that does not require or rely upon a central intermediary like a bank or broker. And all in a way where only the owner of an asset can send it, only the intended recipient can receive it, the asset can only exist in one place at a time, and everyone can validate transactions and ownership of all assets anytime they want.

The key here is that we are in the infancy of the use of cryptocurrencies like Bitcoin. Just as we saw with railroads, cars and the Internet as a whole, there is going to be a lot of volatility. And eventually there will be a shakeout. Some of the currencies won’t last. Some of the apps built on those systems won’t last. In fact, most of them won’t. But the idea, the platform, the application of Bitcoin will last – and that’s what’s important to understand.

Where I see this heading is toward an online payments system that people use as an adjunct to state money in much the same way you would use PayPal or Google Wallet today. There are likely to be network effects as a result, meaning that a network with lots of users will benefit from the size of the network, with that size acting as a barrier to competition. But there will be plenty room for multiple payments systems based on the Bitcoin cryptocurrency technology.

The end result then will be a number of payments systems based on Bitcoin’s platform or a platform very similar to Bitcoin. And these systems will be cheap, global and instantaneous. Here’s Andreessen again:

with Bitcoin, the huge hack that recently stole 70 million consumers’ credit card information from the Target department store chain would not have been possible. Here’s how that would work:

You fill your cart and go to the checkout station like you do now. But instead of handing over your credit card to pay, you pull out your smartphone and take a snapshot of a QR code displayed by the cash register. The QR code contains all the information required for you to send Bitcoin to Target, including the amount. You click “Confirm” on your phone and the transaction is done (including converting dollars from your account into Bitcoin, if you did not own any Bitcoin).

Target is happy because it has the money in the form of Bitcoin, which it can immediately turn into dollars if it wants, and it paid no or very low payment processing fees; you are happy because there is no way for hackers to steal any of your personal information; and organized crime is unhappy. (Well, maybe criminals are still happy: They can try to steal money directly from poorly-secured merchant computer systems. But even if they succeed, consumers bear no risk of loss, fraud or identity theft.)

Why should I even have a bank account? Seriously, think about the unbanked in developed economies or in developing economies. In developed economies, banks are racking up transaction fees and overdraft fees, and late fees. You even have to pay a fee in order to have a bank account unless you meet minimum account requirements. All of that goes away if you use an online payments system for most of your tranactions. And all you need then is a ubiquity of payment like you see with Visa, Mastercard and American Express.

From a transaction perspective, it makes micropayments much easier. And that means it could have developing economy potential too. The move to cheapie smart mobile handsets is gathering pace. And my view here is that the mobile industry will be driven increasingly by the conversion of price-sensitive buyers to cheap smart mobile handsets. This will be especially true in the developing world. And as such, it makes Bitcoin-like payments system a boon for those who want to make small payments using those handsets without bank accounts and at zero to low fee rates.

Bitcoin is a huge threat to the existing fee model of the modern banking system – and it circumvents necessity for accounts.

Who should be threatened by this? PayPal and other online payments systems but also the credit card companies and banks. Banking systems might catch up to or even supplant Bitcoin as a payments system, but they will do so at much lower transaction fees.

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